Stock Star Rating Performance Update

Our stock star ratings held up relatively well under the first-quarter market rally. Five-star stocks, and the strategies based on 5-star stocks, both outperformed the cap-weighted and equal-weighted S&P 500. Even more pronounced was the outperformance of lower quality stocks, which marked much of the 2009 rally, and persisted in the first quarter of 2010.

Star RatingsTo construct our average star rating portfolio returns, we calculate the equal weighted average returns of all stocks with a given rating on a daily basis. We then take the geometric average of those daily returns over the relevant time period. Our average star returns show that 1-star stocks had enormous returns over the last year, lifting all of their trailing period returns. Excluding 1-star stocks, the returns line up roughly as we would hope, with 5-stars outperforming lower rated stocks.

One reason our 1-star stock average portfolio had such high returns is because, as Pat Dorsey mentioned in our 2009 year-end performance article, we were skeptical of how quickly stocks were pricing improvements in the credit markets, which caused us to be behind a few of the higher-risk stocks that exploded over the last year.

In addition, we rated very few stocks 1-star at the bottom of the market in early 2009. In fact, of March 7, 2009, the day the S&P 500 bottomed, only 58 stocks of our 2,102 stock coverage universe were rated 1-star. \

As a result, each stock that remained in the portfolio had significantly more influence over the average return, and a few outliers were able to considerably skew the returns of the average portfolio.

To counter this outlier effect, we also construct portfolios that are reconstituted daily, but use the median return for each rating on a given day to construct portfolio returns. Our median returns line up as we would hope over the last one, three, and five years.

In addition to our average and median rating returns, we also look at rules-based portfolios, which more closely approximate actual investable portfolios. These include our Buy at 5, Sell at Fair Value and Buy at 5, Sell at 3 portfolios. Since inception, and over every trailing period, these strategies have outperformed both the market capitalization weighted S&P 500 and the equal weighted S&P 500.

Quality vs. JunkThe resounding theme of the market's recovery in both 2009 and thus far in 2010 has been the triumph of junk over quality.

As markets plummeted in 2008, highly levered no-moat stocks with large amounts of uncertainty were punished heavily, and as a result are rebounding faster than their safer wide-moat counterparts as general economic and capital market uncertainty has subsided.

This is not a new theme. In fact, we've found that high quality and low quality excess returns are almost always heading in opposite directions--regardless of whether you measure quality by moat, uncertainty, or stewardship--with high quality outperforming in downturns, and low quality outperforming in recoveries.

It should be noted that we do not make any claim that wide-moat, low uncertainty, or generally higher-quality companies should outperform lower-quality companies in the long run. In fact, taking modern financial theory at face value, lower-quality firms may outperform in the long run as a result of the higher systematic risk they face due to investors' herd behavior. The true measure of the return we expect from a stock lies in its valuation alone. Return volatility, on the other hand, is well predicted by our moat and uncertainty ratings.

Combining Moat and ValuationOne of the most powerful ways to use our research is to combine our moat ratings with our fair values.

We find that prices converge to our fair values more often for wide moat stocks, which only makes sense given that we expect these stocks to have persistent competitive advantages that allow them to reliably earn economic profits for a longer period of time.

Although at times there may be greater value dislocations in no-moat stocks, these are less reliable. No-moat investing is comparable to swinging for the fences--sometimes you strike out--whereas wide moat investing is comparable to going for consistent base hits.

Investable StrategiesWhile most of the strategies mentioned above are helpful for the purpose of monitoring our performance, their transaction costs would prohibit anyone from following them with real money. For that reason we also offer more investable strategies based on our stock research such as our Tortoise and Hare portfolios available through Morningstar's StockInvestor newsletter, our Dividend Builder and Dividend Harvest portfolios available through Morningstar's Dividend Investor newsletter, and our Wide Moat Focus Index, which rebalances quarterly to track our twenty cheapest wide moat stocks . Our track records for each of these real investable portfolios have beaten the S&P 500 since inception, and all but the Wide Moat Focus continued their winning streaks in the first quarter of 2010.

Where Are We Now?While we don't pretend to know when the current rally will end, we do believe the market is now more overvalued than it has been since the middle of 2007. Fortunately, that does not mean all the opportunities are gone. A quick look at our price-to-fair value ratios by sector shows that the median stock in the Health Care sector is undervalued. In addition, we have three wide-moat stocks below that are trading at a significant discount to our fair value estimate.

International Speedway CorporationISCAMoat Rating: Wide Uncertainty: HighInternational Speedway is the leading promoter of motorsports entertainment in the United States. The company owns or operates 13 race tracks including the well-known Daytona International Speedway and Talladega Superspeedway. International Speedway hosts more than 100 racing events per year, which generate revenue from admissions, broadcasting rights to the races, food, beverage, merchandise sales, and advertising sponsorships.

Exelon CorporationEXCMoat Rating: Wide Uncertainty: MediumExelon is a holding company with regulated and unregulated divisions. Its regulated division, comprising Commonwealth Edison of Illinois and PECO of Pennsylvania, distributes electricity and natural gas to 5.4 million customers. Its generation division owns base load, intermediate, and peaking plants in seven states. Exelon's 11 nuclear plants generate 80% of the company's total power.

Apollo GroupAPOLMoat Rating: Wide Uncertainty: Medium Apollo is the largest for-profit education company, with more than 450,000 students in its core school, the University of Phoenix. The company offers classes online and through campuses in 40 states, as well as various international locations. Programs range from associate to doctorate degrees in areas such as business, education, health care, technology, and social and behavioral sciences.